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While sole proprietorships and Limited Liability Companies are very different types of business organizations, both have the same choices when it comes to profits. The excess funds could be used to pay debt or re-invested to expand the business. Or, depending on the circumstances, the profits could be distributed to the business owners. Regardless of the choice, sole proprietors and members of the LLC are required to include the business’s profits on their tax returns.

Entity Definitions

A sole proprietorship is arguably the easiest organization to form, as the business consists of one owner-employee and generally does not require state sanction to form. The downside of a sole proprietorship is that the owner is personally liable for the business debts and liabilities.. In an LLC, the owners are generally not held liable for the business’s debts and liabilities. However, for an LLC to organize, it must register with the state and put in place several legal safeguards for the benefit of all of the owners. These legal responsibilities can be quite costly when a business is starting.

Pay Off Liabilities

Paying off business debts and liabilities has little short-term effect but could improve the long-term prospects of the business. The value of a business to its owners is measured by subtracting the outstanding liabilities from the assets. Presuming that each dollar spent to pay down debt would decrease assets and liabilities equally, it would appear that such an action would have no effect on the business’s value. But paying off debts on which the business owes interest can eliminate the future interest expenses, making the business more profitable in the long run.

Invest in Business

Another alternative is for the business to invest its profits in expanding its business. Expanding is not always a good idea; just because a business does well in one market does not mean that expanding to new markets and producing more and new products is a good idea. By participating in capital budgeting, businesses can evaluate opportunities for growth and focus on whether future cash flows are worth the initial cost to obtain that revenue stream. If the process reveals that the investment is profitable, then businesses are more likely to invest. However, these calculations can be complicated and are based on predictions -- which may not turn out as foreseen.

Distribute Funds

The final method is to distribute the funds. Both sole proprietors and LLC members have a right to claim the business’s income for their own purposes. When an owner decides to receive a distribution of the business’s profits, it is generally due to personal considerations, such as she wants to pay down personal debt or acquire a personal asset.

Taxing Owners on Profits

Regardless of what choice a sole proprietorship or LLC makes regarding what to do with its profits, the owners of both entities need to include the business’s income on their personal tax returns. If the individual is a sole proprietor, she must record the business’s income on Schedule C of the Form 1040. If the taxpayer is a member of an LLC, she will receive a Form 1065 K-1 that will detail what income and deductions she needs to claim. The K-1 will also inform the member how to include those items on her return.

About the Author

John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.